Opportunity Loves Flux in the Market : Stocks: History tells us that when volatility is high, prices have routinely been at an important bottom. Fear of turbulence is the most costly error in investing today.

ROBERT D. ARNOTT Robert D. Arnott is president and chief investment officer of First Quadrant Corp., based in Pasadena and Morristown, N.J.

In the 1920s, J.P. Morgan was asked by a reporter what the stock market would do. "It will fluctuate" was his droll response.

The marketplace is full of myths and misconceptions about volatility. Many of these would be amusing if they were not so very costly.

Volatility is bad . Volatility is not inherently bad, but it is frightening. The difference is subtle but important. How many market bottoms have occurred in times of turbulence? Most or all. How many market tops have been characterized by a comfortable stability? Most or all.

History tells us that recent volatility is a fairly good predictor for prospective market returns. When volatility is high, the market has routinely been at an important bottom. When volatility is low, the market has typically fallen.

This is counter-intuitive. Logic would suggest that when risk is high, we ought to be less invested than when risk is low. Indeed, many sophisticated institutional investors, relying on a technique called "optimization," fall prey to precisely this error.

How many investors were selling during the frightening period that fell on the heels of the 1987 market crash? Yet that was a wonderful time to buy. Many sold after the 1973-74 stock market debacle, after the worst bear market since the 1930s. After a decade of disappointment, many bondholders finally bailed out just as bond yields were becoming extraordinarily attractive in 1981-82.

Fear of volatility is the single most costly error made in the investment world today. And the institutional investors are no better than individual investors in their "rational" response to risk.

Comfortable investments are not rewarding. Volatility breeds opportunity. When markets are turbulent, they are likely to be priced to reflect the unease that turbulence creates. Turbulent markets can respond well, can rise sharply as a semblance of "normalcy" returns to the world. Dull (hence, comfortable) markets, on the other hand, cannot tolerate surprise; they plunge at the first hints of turbulence.

Markets are more volatile than they used to be. Before the "mini-crash" of Oct. 13, the volatility of the stock market had fallen to the lowest levels seen since the "real crash" of October, 1987. Indeed, in the weeks leading up to Oct. 13, stocks were becoming downright boring. In the days since the "mini-crash," of course, volatility has been up--a 7% move in one day has always been an unusual event.

But think back to 1982. Then there were more than 20 days in which the Dow moved by over 2% in a day (roughly 16 points at 1982 levels). During the third quarter of 1989, the Dow moved over 2% exactly once, on Aug. 24.

The reason that the markets now seem more volatile is threefold:

--The market levels are much higher than in past years. That move of 16 points, which in 1982 was fully 2%, is now not even one-third as large on a percentage basis.

--The memory of the fourth quarter of 1987 lingers. The markets were extraordinarily volatile then. The volatility (absent this past two weeks) has dissipated, but the memory most assuredly has not.

Program trading and futures and options have made markets riskier. History demonstrates that markets were more volatile before these developments arrived. Program trading is nothing more than an arbitrage between two markets. Because it does not involve net buying or selling (rather, it involves both buying and selling, simultaneously, and in identical amounts), it cannot move the markets. It pushes futures up and stocks down (or vice versa) simultaneously, and by a like amount. It simply exploits mispricing between the two. Arguably, this activity should dampen volatility. Without program trading, there would be no mechanism to keep the two sets of markets fairly priced relative to each other.

The investor armed with a full understanding of the nature of risk will prosper at the expense of those who overreact. Turbulence is frightening, and for that very reason it often offers good opportunities to buy. Stability is comfortable, and for that very reason it often is characteristic of market tops.

Markets have been frightfully turbulent for a few days. But the message is clear. Successful investors become wary when markets become too comfortable, as was the case in August and September. They pounce on opportunities when it is least comfortable to do so. The markets do not reward comfort.